Belgium bank bond deals show investors losing the plot

LONDON, Jan 25 (IFR) - Investors piled into covered bonds from Belgium's Belfius Bank and KBC bank this week that priced 20bp through the sovereign curve, extending a euphoric rally that many think is overdone.

Indeed, some said the sales showed that investors are failing to properly assess the European bank risk they are taking on, raising fears of a painful correction ahead.

"It makes little sense to be placing a higher value on relatively weak bank debt over a non-peripheral government bond," said an investor who declined to buy into either Belfius or KBC.

"In countries like Spain and Italy, it is rational that some of the national champions would price through their sovereigns. But in Belgium, Belfius and KBC are hardly strong credits."

Although covered bonds from peripheral national champions such as BBVA, Santander, Intesa and UniCredit are backed by mortgages, they also provide dual recourse to the issuers, which are considered well-diversified - and less likely to run into trouble.

In Belgium, by contrast, banks like KBC, Dexia and Fortis have had to seek government assistance, while the sovereign is in better shape.

Aa3/AA/AA rated Belgium in fact saw its outlook upgraded to stable from negative by Fitch this week on the back of the country's budget consolidation.

The surprise reception to the Belfius and KBC issues means French banks could be next up, after CFF this week tapped its 2.375% November 2022 bond for EUR750m flat to the government.

But bankers said strong French borrowers such as BNP Paribas were in the same camp as the solid Spanish names.

"French bank paper looks very cheap these days," said one syndicate banker.

"In the wake of these Belgian deals, I think the big credits in France could price through the sovereign, especially at the long end."

TROUBLE AHEAD

Just six months ago, the majority of European banks were expected to pay a premium to their underlying sovereigns, regardless of jurisdiction.

That all changed following the announcement of the ECB's sovereign backstop in the summer, which has driven the Financials Index 100bp tighter and provided investors with more confidence to start buying bank paper again.

Spain, Irish and Portuguese banks - locked out of the capital markets for months - are now funding again at relatively sustainable costs, and often through their sovereigns.

But there is concern that the market has become undisciplined, especially as economic fundamentals remain shaky.

The International Monetary Fund expects Spain to remain in recession through much of 2013. Italy, having recorded a 0.2% economic contraction last year according to government figures, is predicted to decline 0.7% this year.

Swathes of investors, under pressure to put huge amounts of cash to work, are finding it tough to show restraint and naturally fear missing out on a rally that has taken everyone by surprise in its ferocity.

"We are all having to make returns, and while a correction seems probable, you cannot sit on your hands while everyone else is making money," said one investor.

READING THE SIGNS

There are already signs that the rally is running out of steam, prompting analysts to warn about a more severe pullback.

"We would be inclined to wait for markets to re-price more meaningfully before adding risk," analysts at Barclays said.

"In the interim, investors should look for cheap ways to own downside volatility."

Italian elections, the second fiscal cliff and the possibility of poor earnings from European companies are just a few of the headwinds facing the market.

And the Banca Monte dei Paschi di Siena derivatives shock, which could cost the bank as much as EUR720m, has sparked concerns that second-tier European banks have more skeletons in their closets than they are letting on. (Reporting by Aimee Donnellan; editing by Natalie Harrison, Philip Wright & Marc Carnegie)